The Court of Appeals for the First Circuit, in Kaufman v. Shulman, Docket No. 11-2017P-01A (1st Cir., July 19, 2012), reversed a Tax Court decision siding with the IRS which had disallowed a couple’s conservation easement deduction. The Tax Court had disallowed the deduction because a provision in a subordination agreement with the couple’s lender violated the Treasury Regulations’ “extinguishment provision”. The Court of Appeals reversed the Tax Court, finding that the Tax Court and IRS interpretation of this regulation was unreasonably restrictive and inconsistent with Congressional intent.
Treasury Regulation Section 1.170A-14(g)(6) provides that “if a subsequent unexpected change in the conditions surrounding the property that is” subject to a conservation easement “can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee’s proceeds from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution…..accordingly, when a change in conditions gives rise to the extinguishment of a perpetual conservation restriction, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.”
The IRS and the courts have generally held this regulation to mean that a mortgagee or deed of trust holder’s mortgage or deed of trust must be fully subordinated to the easement holder’s interest in the property subject to the conservation easement. The Tax Court in Kaufman held that the subordination agreement entered into by the taxpayers and their lender invalidated any claim of deduction, as it provided that “[t]he Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds . . . and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged.”
The First Circuit disagreed. It characterized the Tax Court’s and IRS’s reading of Regulation Section 1.170A-14(g)(6) as overly restrictive, with the result of negating practically all deductions for easement donations “surely contrary to the purpose of Congress.” Although the lender retained priority to insurance proceeds, the Court of Appeals observed that the Kaufmans had no power to make the lender give up this protection. The Court of Appeals also noted that the word “entitled” could be interpreted as meaning that the easement holder’s right to proceeds was absolute as against the donor. Further, the Court of Appeals noted that tax liens could potentially trump a donee’s right to funds upon extinguishment of the easement. Therefore, the Court of Appeals found that the Tax Court’s reading of the regulation’s “entitled” language as requiring that a donee have an “absolute right” to any proceeds was impracticable and contrary to the statute’s intended purpose.
Subordination of lenders’ rights has long been an impediment to conservation easements. Many lenders holding mortgages on property not yet subject to easements are reluctant to fully subordinate their existing rights in order to allow a tax benefit to borrowers. The First Circuit’s holding in Kaufman is by no means the settled law of subordination, but the Tax Court has applied its Kaufman reasoning in several other decisions which are currently under appeal. As, and if, the Courts of Appeal move to adopt a less restrictive reading of these regulations, potential easement donors may find that their lenders are now more willing to consent to subordinating their rights and to allow these donors to implement their conservation and tax planning desires.